About that Diamond ETF Idea

By Brendan Conway

If you read this blog or my weekly print Barron’s column, you’re aware that a diamond ETF — diamond as in gemstone — could be on its way. A reader emails with a point that I glossed over both times I’ve written on the subject: We’re hard-pressed to find a case where an ETF effectively created a new public market for a given investing exposure. There is generally an exchange-traded market of some sort, somewhere, even for physically backed funds like this one, before a given exposure can be turned into an ETF.

The proposed IQ Physical Diamond Trust would essentially need to create and define the public market for diamonds, or some reliable proxy for it, in order to be successful. As we noted in our coverage, there’s no futures market, and diamonds remain a very clubby domain. Even the “spot” price that diamond traders around the globe are willing to pay can be tough for outsiders to know reliably.

Index IQ’s solution is to create or select an as-of-yet-unannounced pricing mechanism; you can read the full proposal in the SEC filing here. But if IndexIQ ends up with a mechanism that’s completely unrelated to existing assets trading on the exchange, and does so successfully, it would appear to be a first. ETFs are, broadly speaking, are a derivative product, taking their price cues from some underlying asset.

Successful ETFs that track relatively thin slices of the commodities universe tend to have futures markets already in place, even when they’re physically backed. One good example is the $525 million ETFS Physical Palladium Shares (PALL).

There is the precedent of creating statistical indexes to define oddball asset classes, such as stocks’ volatility. That may be one relevant precedent. But the biggest such volatility trading product, the $1.6 billion Barclays iPath S&P 500 Short Term VIX Futures ETN (VXX), ultimately traces back to an index of futures that trade on the Chicago Board Options Exchange. The same is true for other funds and notes in this niche. The statistical VIX index at the heart of U.S. volatility trading developed a reasonably well-traded public market of futures and options before ETFs and ETNs could take off. And the whole point of creating volatility trading was to give investors an asset linked to a characteristic — volatility — of the Standard & Poor’s 500 index.

The upshot is that the diamond ETF is a pretty ambitious idea on technical grounds alone, one that is already attracting its share of skepticism.

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